It’s largely an issue of accounting, but we anticipate that Greek debt could end up higher at the end of 2011 than previously forecast–even if the entire debt-reducing discount bond-buyback program and most of the discount bond-exchange program happen this year.

Why’s that? The problem is the bond exchange. As we’ve previously laid out, the bond exchange will swap €135 billion of old Greek debt for €121.5 billion in new debt, cutting the total debt stock by €13.5 billion.

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Eventually.

But first, Greece must borrow money to fund the purchase of collateral that backs the newly exchanged bonds. That new borrowing more than offsets the savings. In all, we estimate that the exchange means the debt stock will rise by €18 billion by the end of 2011, if it goes through this year.

That will cancel the entire reduction from the €12.6 billion expected separately to be reaped from below-market purchases of Greek debt, and then some.

Of course, Greece will have an offsetting financial asset–the collateral–but the rules used by the EU to compute debt ratios rest on a definition of gross debt, not debt reduced by the value of assets, financial or otherwise.

And, decades hence, Greece will get to liquidate the financial asset to repay debt, with a corresponding drop in the debt stock. But for now, up it goes.

So, how does the math work? Buckle up.

The Institute of International Finance, the lobby group that negotiated with EU governments, put forward a plan that foresees €135 billion in bond rollovers. The IIF splits the rollovers into four equal categories (€33.75 billion each):

1.) A par bond exchange, fully collateralized by zero-coupon bonds. This means an investor holding a €100 Greek bond turns it in and gets a new €100 bond maturing in 30 years’ time (2041). This has no net effect on the debt level. But Greece must immediately borrow cash from the EFSF to purchase a zero-coupon bond with a face value of €100 to hold as collateral. Zero-coupon bonds are bought below face value, and interest is added until the bond reaches the full face amount at maturity. Let’s assume it costs around €34 now to buy a 30-year triple-A-rated zero-coupon bond with €100 face value. Thus Greece’s debt rises by €34 for every €100 of exchanged bonds. For €33.75 billion in exchanged bonds, that’s €11.5 billion in new debt.

2.) A discount bond exchange, fully collateralized by zero-coupon bonds. For every €100 turned in, the creditor gets €80 in new bonds; that €80 is fully collateralized in the same way. (These bonds pay higher interest that the bonds in choice No. 1, above.) So for every €100 in bonds exchanged, Greece issues €80 in new bonds, cutting debt by €20. It then borrows to buy €27.2 (€34 times .8) in collateral. Net: €7.2 in new debt per €100 exchanged, or €2.4 billion in new debt for this €33.75 billion.

3.) A discount bond exchange, partly collateralized (up to 40% of notional value) by cash sitting in an escrow account. For every €100 turned in, the creditor gets €80, and Greece must borrow €32 (40% of €80) to stuff in the escrow account. So Greece cuts debt by €20 for every €100 turned in, then adds €32 in new debt to fill the escrow account. Net, €12 per €100. Or €4.1 billion in new debt on the €33.75 billion.

4.) A par exchange when the holders’ bonds mature. The last benchmark Greek bond coming due in 2011 matures on August 20, so we’ll assume the whole deal happens after that day. Hence we don’t have to worry about this chunk for 2011 debt numbers. Phew.

The grand total from items 1 to 3 above: €18 billion.

The European Commission projected before the new bailout that Greece’s debt would rise from €328.6 billion at the end of 2010 to €352.6 billion at the end of 2011. Adding the €18 billion gets us to €370.6 billion, or 164.7% of GDP, instead of a forecast of 156.7%.

If the entire €12.6 billion is realized from buybacks, the ratio falls to 159.1%. But still ahead of the previous forecast.

These numbers don’t reflect any other changes to the debt flows brought about by the new bailout. For instance, additional borrowing to fund bank recapitalization would kick the debt ratio higher.

The very wonky among you Loyal Readers may be wondering how this all affects Greece’s deficit. There are two issues here:

First, on a long term basis, the impact is negligible. The interest Greece pays the EFSF on the money it borrowed to purchase the collateral (or put in escrow) increases the deficit. But the interest it receives on the escrow account and the imputed interest from the zero-coupon bond both decrease the deficit. This should be a wash.

Second, there’s the large cash outflow in 2011 to purchase collateral. As we understand the EU accounting system, acquisitions of financial assets are not counted against the deficit. There should be no impact here. (Readers, please let us know if you have a firmer answer on this.)

So the debt level can rise independently of the deficit? Yep. In case you’re really curious or insomniac, the discrepancies between the yearly deficit and the year-to-year change in the debt level are recorded in something called the stock-flow adjustment. We’d anticipate that the purchase of collateral will result in a large negative position in the net acquisition of financial assets line of the stock-flow adjustment.

Comments (5 of 5)

The debt of 135 billion works out to 11250 for every citizen of Greece. The fair way forward is that the lender should make this an interest fee loan for first 5 years than next 5 years interest rates should be half of Central bank lending rate , moving to Central bank interest rate for another 10 years.. This will mean every citizen paying under 12 Euro's a week. Greece should stop borrowing any more
Demanding that Greek citizens keep paying high interest rates will not work and the holders of the bonds will loose every thing

4:29 pm July 31, 2011

RogerB34 wrote:

The problem is not in bailout debt.
The problem is in calculation of bailout debt effect on the economy.
The USA model is best: $1 of debt = $1.50 of GDP.
Use the USA model and EU sovereign debt misery will be over and another Nobel for Obama.

4:50 pm July 27, 2011

stavroulita wrote:

the political culture of Greece will not change any time sooner....so one thing that can be done is that the Greek government should give away it's sovereign rights to the European Comission....and not to the USA .....THE EU SHOULD START THINKING THROUGH IT'S FOREIGN POLICY....CLOSE SOME BOARDERS ...AND REORGANIZING IT SELF AS A FEDERAL STATE....MAYBE THIS SEEMS TOO MUCH ....BUT THAT WAS THE WHOLE DEAL FROM THE BEGINNING OF THIS UNITY....THE USA SHOULDN'T BE ALLOWED TO MEDDLE ANY LONGER

3:43 pm July 26, 2011

Steve Borsher wrote:

The epitome of throwing good money after bad.

11:07 am July 26, 2011

Paco wrote:

I not know why Germany keeps pay so much to Greece? Will this not drain germany? It is not for benefit of Germany and France I think. But if they want to pay more money then good, I will take some too.

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The Wall Street Journal’s Brussels blog is produced by the Brussels bureau of The Wall Street Journal and Dow Jones Newswires. The bureau has been headed since 2009 by Stephen Fidler, who was previously a correspondent and editor for the Financial Times and Reuters. Also posting regularly: Matthew Dalton, Viktoria Dendrinou, Tom Fairless, Naftali Bendavid, Laurence Norman, Gabriele Steinhauser and Valentina Pop.